November 2011

The last decade has seen a tremendous transformation in the global financial sector. Globalization, innovations in communications technology and de-regulation have led to significant growth of financial institutions around the world. These trends had positive economic benefits in the form of increased productivity, increased capital flows, lower borrowing costs, and better price discovery and risk diversification. But the same trends have also lead to greater linkages across financial institutions around the world as well as an increase in exposure of these institutions to common sources of risk. The recent financial crisis has demonstrated that financial institutions around the world are highly inter-connected and that vulnerabilities in one market can easily spread to other markets outside of national boundaries.

In a recent paper my co-author Deniz Anginer and I examine whether the global trends described above have led to an increase in co-dependence in default risk of commercial banks around the world. The growing expansion of financial institutions beyond national boundaries over the past decade has resulted in these institutions competing in increasingly similar markets, exposing them to common sources of market and credit risk. During the same period, rapid development of new financial instruments has created new channels of inter-dependency across these institutions. Both increased interconnections and common exposure to risk makes the banking sector more vulnerable to economic, liquidity and information shocks.

Credit information and credit reporting systems are critical to a modern financial sector’s infrastructure. Since past behavior is one of the most powerful indicators of future behavior, credit reports which detail payment histories provide lenders with a valuable tool to classify the risk posed by different borrowers. Credit reporting systems reduce the impact of asymmetric information on credit markets, both by helping lenders to more effectively screen borrowers and avoid adverse selection and by providing an incentive for borrowers to repay their loans—thus reducing moral hazard.

These systems are very well developed in North America and parts of Western Europe but are relatively new in most of the world. As data from the World Bank’s Doing Business database shows (see Figure 1 below), only a small fraction of adults are covered even where credit bureaus do operate. Even in Latin America, which has the best coverage of any emerging market region, only about one third of adults are covered. In many other regions, significantly fewer than 10% of adults have a credit report, and those who are in the system are likely to be high-income consumers with bank loans, not customers of microfinance lenders or retail credit providers.

AAF blog readers who are in Washington, DC this week may be interested in attending an event this Wednesday on Conflict Between an International Financial Agreement and the Borrower’s Domestic Law: Which One Prevails?. The event is part of the World Bank Group's annual Law, Justice and Development week. More details on the event are here, and full details on the LJD week are here.

On October 24, I spoke at the Shadow Regulatory Commission Summit on the Future of Bank Regulation, which was held at the American Enterprise Institute for Public Policy and Research. The full video from the event is available here, and pointers to my contributions are available here.

For better or worse, banking is back in the headlines. From the desperate efforts of crisis-struck Eurozone governments to the Occupy Wall Street movement currently spreading across the globe, the future of banking is hotly debated. A new compilation of short essays by leading financial economists from the U.S. and Europe analyzes the short-term challenges in addressing the Euro-crisis as well as the medium- to long-term regulatory issues. The essays cover a wide variety of topics, ranging from Eurobonds to ring-fencing and taxation, but there are several themes that come through across the chapters. First, many reforms have been initiated or are under preparation, but they are often only the first step towards a safer financial system. Second, there is a need to change banks’ incentive structure in order to reduce aggressive risk-taking. Third, there is an urgent – also political – need to move away from privatizing gains and nationalizing losses, thus from bailing out to bailing in bank equity and junior debt holders.

I will not be able to touch on all the topics discussed in the book, so let me discuss some of the main messages in more detail. Ring fencing – the separation of banks’ commercial and trading activities, known as the Volcker Rule but also recommended by the Vickers Commission in the UK – continues to be heavily discussed among economists. While Arnoud Boot thinks that “heavy-handed intervention in the structure of the banking industry … is an inevitable part of the restructuring of the industry”, Viral Acharya insists that it is not a panacea as long as incentive problems are not addressed. Banks might still undertake risky activities within the ring or might even have incentives to take more aggressive risk. Capital regulations have to be an important part of the equation.

I don’t think so. You may think this is an odd statement since nearly every country around the world has been busy either introducing or at least expanding its insurance coverage since the 2008 financial crisis. This is not surprising, considering that the U.S. was also in the midst of a banking crisis in 1933 when it first introduced deposit insurance.

But think of it this way. Deposit insurance is not meant to stop systemic crises; as we all know by now, governments do that. The purpose of deposit insurance is to protect individual banks from bank runs, mostly during normal times. Since large banks already have implicit protection because they are perceived to be “too-big-to-fail,” deposit insurance is really there to keep small banks in business. To the extent we believe small banks have an important role to play in supporting small, local businesses, this may be a worthy goal. But why do we still have deposit insurance for large banks?